Risk and Valuation of Collateralized

Debt Obligations
Darrell Duffie and Nicolae Gârleanu
In this discussion of risk analysis and market valuation of collateralized
debt obligations, we illustrate the effects of correlation and prioritization
on valuation and discuss the “diversity score” (a measure of the risk of the
CDO collateral pool that has been used for CDO risk analysis by rating
agencies) in a simple jump diffusion setting for correlated default
intensities.

collateralized debt obligation is an asset- main issue we address is the impact of the joint

A backed security whose underlying collat-

eral is typically a portfolio of (corporate
or sovereign) bonds or bank loans. A CDO
cash flow structure allocates interest income and
principal repayments from a collateral pool of dif-
ferent debt instruments to a prioritized collection
of CDO securities, which we call “tranches.”
Although many forms of prioritization exist, a stan-
dard prioritization scheme is simple subordination:
Senior CDO notes are paid before mezzanine and
lower subordinated notes are paid, with any resid-
ual cash flow paid to an equity piece. We provide
some examples of prioritization later in this article.
A cash flow CDO is one for which the collateral
portfolio is not subjected to active trading by the
CDO manager, which implies that the uncertainty
regarding interest and principal payments to the
CDO tranches is induced mainly by the number
and timing of defaults of the collateral securities. A
market-value CDO is one in which the CDO tranches
receive payments based essentially on the marked-
to-market returns of the collateral pool, as deter-
mined largely by the trading performance of the
CDO manager. We concentrate here on cash flow
CDOs, thus avoiding an analysis of the trading
behavior of CDO managers.
A generic example of the contractual relation-
ships involved in a CDO is shown in Figure 1. The
collateral manager is charged with the selection
and purchase of collateral assets for the CDO spe-
cial-purpose vehicle (SPV). The trustee of the CDO
is responsible for monitoring the contractual provi-
sions of the CDO. Our analysis assumes perfect
adherence to these contractual provisions. The
Darrell Duffie is James I. Miller Professor of Finance and
Nicolae Gârleanu is a graduate student at the Stanford
University Graduate School of Business.
distribution of default risk of the underlying collat-
eral securities on the risk and valuation of the CDO
tranches. We are also interested in the efficacy of
alternative computational methods and the role of
“diversity scores,” a measure of the risk of the CDO
collateral pool that has been used for CDO risk
analysis by rating agencies.
CDO Design and Valuation
In perfect capital markets, CDOs would serve no
purpose; the costs of constructing and marketing a
CDO would inhibit its creation. In practice, CDOs
address some important market imperfections.
First, banks and certain other financial institutions
have regulatory capital requirements that make
valuable the securitizing and selling of some por-
tion of their assets; the value lies in reducing the
amount of (expensive) regulatory capital they must
hold. Second, individual bonds or loans may be
illiquid, which reduces their market values; if secu-
ritization improves their liquidity, it raises the total
valuation to the issuer of the CDO structure.
In light of these market imperfections, at least
two classes of CDOs are popular. The balance sheet
CDO, typically in the form of a collateralized loan
obligation (CLO), is designed to remove loans from
the balance sheets of banks, thereby providing cap-
ital relief and perhaps also increasing the valuation
of the assets through an increase in liquidity.1 An
arbitrage CDO, often underwritten by an invest-
ment bank, is designed to capture some fraction of
the likely difference between the total cost of
acquiring collateral assets in the secondary market
and the value received from management fees and
the sale of the associated CDO structure. Balance
sheet CDOs are normally of the cash flow type.
Arbitrage CDOs may be collateralized bond obli-
gations and have either cash flow or market-value
structures.

January/February 2001 41
Financial Analysts Journal
Figure 1. Typical CDO Contractual Relationships
Collateral
Manager
Underlying
Securities
(collateral)
Senior Fixed/
Floating-Rate
Notes
Source: Morgan Stanley, from Schorin and Weinreich (1998).
Among the sources of illiquidity that promote,
or limit, the use of CDOs are adverse selection,
trading costs, and moral hazard.
With regard to adverse selection, enough pri-
vate information may exist about the credit quality
of a junk bond or a bank loan that an investor is
concerned about being “picked off” when trading
such an instrument. For instance, a better-informed
seller has an option to trade or not at the given
price. The value of this option is related to the
quality of the seller’s private information. Given
the risk of being picked off, the buyer offers a price
that, on average, is below the price at which the
asset would be sold in a setting of symmetric infor-
mation. This reduction in price as a result of
adverse selection is sometimes called a “lemon’s
premium” (Akerlof 1970).
In general, adverse selection cannot be elimi-
nated by securitization of assets in a CDO, but it can
be mitigated. The seller achieves a higher total
valuation (for what is sold and what is retained) by
designing the CDO structure so as to concentrate
into small subordinate tranches the majority of the
risk that may be cause for adverse selection. For
example, a large senior tranche, relatively immune
to the effects of adverse selection, can be sold at a
small lemon’s premium. The issuer can retain, on
average, significant fractions of the smaller subor-
dinate tranches, which are more subject to adverse
selection. For models supporting this design and
retention behavior, see DeMarzo (1999) and
DeMarzo and Duffie (1999).
42 ©2001, Association for Investment Management and Research®
Ongoing
Communication
Trustee
CDO
Hedge Provider
Special-Purpose
(if needed)
Vehicle
Mezzanine
Subordinated
Fixed/Floating-
Notes/Equity
Rate Notes
For a relatively small junk bond or a single
bank loan to a relatively obscure borrower, the
market of potential buyers and sellers may be
small; thus, trading may be costly.2 Searching for
such buyers can be expensive, for example, and to
sell such an illiquid asset quickly, one may be
forced to sell to the highest bidder among the rela-
tively few buyers with whom one can negotiate on
short notice. One’s negotiating position may also
be poorer than it would be in an active market. The
value of the asset is correspondingly reduced.
Potential buyers recognize that they are placing
themselves at the risk of facing the same situation
when they try to resell in the future, which results
in yet lower valuations. The net cost of bearing
these costs may be reduced through securitization
into relatively large homogeneous senior CDO
tranches, perhaps with significant retention of
smaller and less easily traded junior tranches.
Moral hazard, in the context of CDOs, bears on
the issuer’s or CDO manager’s incentives to select
high-quality assets for the CDO and to engage in
costly enforcement of covenants and other restric-
tions on the behavior of obligors. Securitizing and
selling a significant portion of the cash flows of the
underlying assets dilute these incentives. Reduc-
tions in value through lack of effort are borne to
some extent by investors. Also, the opportunity
may arise for “cherry picking” (sorting assets into
the issuer’s own portfolio or into the SPV portfolio
based on the issuer’s private information). In addi-
tion, opportunities may arise for front running, in
which a CDO manager trades on its own account

in advance of trades on behalf of the CDO. These
moral hazards act against the creation of CDOs,
because the incentives to select and monitor assets
promote greater efficiency and higher valuation if
the issuer retains a 100 percent interest in the asset
cash flows.
The opportunity to reduce the other market
imperfections through a CDO may be sufficiently
large—especially in light of the advantages in
building and maintaining a reputation for not
exploiting CDO investors—to offset the effects of
moral hazard. In this case, the issuer has an incen-
tive to design the CDO so that the issuer retains a
significant portion of one or more subordinate
tranches that would be among the first to suffer
losses stemming from poor monitoring or poor
asset selection. Doing so demonstrates a degree of
commitment to diligent efforts to manage the issue.
Similarly, for arbitrage CDOs, a significant portion
of the management fees may be subordinated to the
issued tranches (Schorin and Weinreich 1998). In
light of this commitment, investors may be willing
to pay more for tranches, and the total valuation to
the issuer will be higher than in an unprioritized
structure, such as a straight equity pass-through
security. Innes (1990) described a model that sup-
ports this motive for security design.
An example of a CLO structure consistent with
this theory is shown in Figure 2. The figure illus-
trates one of a pair of CLO cash flow structures
issued by NationsBank in 1997. A senior tranche of
$2 billion in face value, whose credit rating is AAA,
is followed by successively lower subordination
Figure 2. NationsBank CLO Tranches for Three-Year Floating Rate Notes
Obligors
$2,164 million
Issuer Interest Rate Swaps
A. $2,000 million
(AAA) B. $43 million
(A)
Source: Fitch.
January/February 2001
Risk and Valuation of Collateralized Debt Obligations
tranches, with their ratings. The bulk of the under-
lying assets are floating-rate NationsBank loans
rated BBB or BB. Any fixed-rate loans were hedged
in terms of interest rate risk by fixed-to-floating
interest rate swaps. As predicted by theory,
NationsBank retained the majority of the (unrated)
lowest tranche.
Our valuation model does not deal directly
with the effects of market imperfections. It takes as
given the default risk of the underlying loans and
assumes that investors are symmetrically
informed. Although this approach is not perfectly
realistic, it is not necessarily inconsistent with the
roles of moral hazard or adverse selection in the
original security design. For example, DeMarzo
and Duffie demonstrated a “fully separating equi-
librium,” in which the sale price of the security or
the amount retained by the seller signals to all
investors any of the seller’s privately held value-
relevant information. Moral hazard can be
addressed by the model because the diligence of the
issuer or manager is, to a large extent, determined
by the security design and the fractions retained by
the issuer. Once these factors are known, the
default risk of the underlying debt is also known.
Our simple model does not, however, account for
the valuation effects of many other forms of market
imperfections. Moreover, inferring separate risk
premiums for default timing and default recovery
from the prices of the underlying debt and market
risk-free interest rates is generally difficult (see
Duffie and Singleton 1999.) These risk premiums
C. $54 million
(BBB)
D. $64 million
(not rated)
43
Financial Analysts Journal
play separate roles in the valuation of CDO
tranches. We simply take these risk premiums as
given in the form of “risk-neutral” parametric mod-
els for default timing and recovery distributions
under an equivalent martingale measure.
Default Risk Model
We lay out some of the basic default modeling for
the underlying collateral. First, we propose a sim-
ple model for the default risk of one obligor. Then,
we turn to the multi-issuer setting. Throughout, we
work under risk-neutral probabilities, so value is
given by expectations of discounted future cash
flows. If objective likelihoods or variances are of
interest, however, the results should be interpreted
as if the probabilities were actual, not risk neutral.
Obligor Default Intensity. We suppose that
each underlying obligor defaults at some expected
arrival rate. The idea is that at each time t before the
default time τ of the given obligor, the default
arrives at some “intensity” λ(t), given all currently
available information. We thus have the approxi-
mation
P t ( τ < t + ∆t ) ≅ λ ( t )∆t
for the conditional probability at the time t of
default within a “small” time interval ∆t > 0.3 For
example, if time is measured in years (as we do
here), a current default intensity of 0.04 implies that
the conditional probability of default within the
next three months is approximately 0.01. Immedi-
ately after default, the intensity drops to zero. Sto-
chastic variation in the intensity over time, as new
information becomes available, reflects any
changes in perceived credit quality. Correlation
across obligors in the changes over time of their
credit qualities is reflected by correlation in the
changes of those obligors’ default intensities.
Indeed, our model has the property that all correla-
tion in default timing arises in this manner.4 We call
a stochastic process λ a pre-intensity for a stopping
time τ if whenever t < τ, first, the current intensity
is λt and, second,
Pt ( τ > t + s ) = E t [ exp ( ∫t
t+s
– λ u du ) ] , s >0,
where Et denotes conditional expectation given all
information at time t and s is the length of the
period over which survival (no default) is consid-
ered. A pre-intensity need not fall to zero after
default. For example, default at a constant pre-
intensity of 0.04 means that the intensity itself is
0.04 until default and is zero thereafter.
44
We adopt a pre-intensity model that is a special
case of the “affine” family of processes that have
been used for this purpose and for modeling short-
term interest rates.5 Specifically, we suppose that
each obligor’s default time has some pre-intensity
process λ solving a stochastic differential equation
of the form
dλ ( t ) = κ [ θ – λ ( t ) ]dt + σ λ ( t ) dW( t ) + ∆J ( t ) , (3)
where W is a standard Brownian motion and ∆J(t)
denotes any jump that occurs at time t of a pure-
jump process J, independent of W, whose jump
sizes are independent and exponentially distrib-
uted with mean µ and whose jump times are those
of an independent Poisson process with mean jump
arrival rate l . (Jump times and jump sizes are also
independent.6) We call a process λ of this form
(Equation 3) a basic affine process with parameters (κ,
θ, σ, µ, l ). These parameters can be adjusted in
several ways to control the manner in which default
risk changes over time. For example, we can vary
the mean-reversion rate κ, the long-run mean
m = θ + ( l µ ) ⁄ κ , or the relative contributions to
the total variance of λt that are attributed to jump
risk and to diffusive volatility.
We can also vary the relative contributions to
(1)
jump risk of the mean jump size µ and the mean
jump arrival rate l . A special case is the no-jump
(l = 0) model of Feller (1951), which was used by
Cox, Ingersoll, and Ross (1985) to model interest
rates. From the results of Duffie and Kan (1996),
we can calculate that for any t and any s ≥ 0,
α ( s ) + β ( s )λ ( t )
E t [ exp ( ∫t
t+s
– λ u du ) ] = e , (4)
where explicit solutions for the coefficients α(s) and
β(s) are provided in Appendix A. Together, Equa-
tion 2 and Equation 4 give a simple, reasonably rich,
and tractable model for the default time probability
distribution and how it varies at random over time
as information arrives in the market.
Multi-Issuer Default Model. To study the
implications of changing the correlation in the
default times of the various participations (collat-
eralizing bonds or loans) in a CDO while holding
constant the default risk model of each underlying
(2) obligor, we will exploit the following result. We
state that a basic affine model can be written as the
sum of independent basic affine models as long as
the parameters κ, σ, and µ governing, respectively,
the mean reversion rate, diffusive volatility, and
mean jump size are common to the underlying pair
of independent basic affine processes.
Proposition 1: Suppose X and Y are indepen-
dent basic affine processes with respective
©2001, Association for Investment Management and Research®

parameters (κ, θX, σ, µ, l X) and (κ, θY, σ, µ, l Y).
Then, X + Y is a basic affine process with
parameters (κ, θ, σ, µ, l ), where l = l X + l Y and
θ = θX + θY.7
This result allows us to maintain a fixed, par-
simonious, and tractable one-factor Markov model
for each obligor’s default probabilities while vary-
ing the correlations between different obligors’
default times, as explained in the following discus-
sion.
Suppose that the N participations in the collat-
eral pool have default times τ1, . . ., τN with pre-
intensity processes λ1, . . ., λN, respectively, that are
basic affine processes.8 To introduce correlation in
a simple way, we suppose that
λi = Xc + Xi, (5)
where Xc and Xi are basic affine processes with,
respectively, parameters (κ, θc, σ, µ, l c) and (κ, θi, σ,
µ, l i) and where X1, . . ., XN and Xc are independent.
By Proposition 1, λi is itself a basic affine process
with parameters (κ, θ, σ, µ, l ), where θ = θc + θi and
l = l c + l i. One may view Xc as a state process
governing common aspects of economic perfor-
mance in an industry, sector, or currency region and
Xi as a state variable governing the idiosyncratic
default risk specific to obligor i. The parameter
l
ρ = ----c- , (6)
l recovered fraction of face value is uniformly dis-
is the long-run fraction of jumps to a given obligor’s
intensity that are common to all (surviving) obli-
gors’ intensities. One can also see that ρ is the
probability that the pre-intensity λj jumps at time t
given that λi jumps at time t for any time t and any
distinct i and j. We also suppose that θc = ρθ.
Sectoral, Regional, and Global Risk. Exten-
sions of the model to handle multifactor risk
(regional, sectoral, and other sources) could easily
be incorporated with repeated use of Proposition 1.
Suppose, for example, that we have S different
sectors. We denote by c(i) the sector to which the ith
obligor belongs; consequently, c(1), c(2), . . ., c(S) are
disjoint and exhaustive subsets of (1, 2, . . ., N).
Suppose that the default time τi of the ith obligor
has a pre-intensity λi = Xi + Yc(i) + Z, where the
sector factor Yc(i) is common to all issuers in the
“sector” c(i), where Z is common to all issuers, and
where (X1, . . ., XN, Y1, . . .,YS, Z) are independent
basic affine processes.
If we do not restrict the parameters of the
underlying basic affine processes, then an individ-
ual obligor’s pre-intensity need not itself be a basic
affine process, but calculations are nevertheless
January/February 2001
Risk and Valuation of Collateralized Debt Obligations
easy. We can use the independence of the underly-
ing state variables to see that
 
E t  exp [ ∫t – λ i ( u ) du ] 
t+s
  (7)
= exp[α ( s ) + β i ( s )X i ( t ) + β c ( i ) ( s )Y c ( i ) ( t ) + β z ( s )Z ( t ) ] ,
where α(s) = αi(s) + αc(i)(s) + αZ(s) and all the α and
β coefficients are obtained explicitly from Appen-
dix A, from the respective parameters of the under-
lying basic affine processes Xi, Yc(i), and Z.
Even more generally, we can adopt multifactor
affine models in which the underlying state vari-
ables are not independent. Interest rates that are
jointly determined by an underlying multifactor
affine jump diffusion model can also be accommo-
dated. We refer the interested reader to the Duffie
and Gârleanu 1999 working paper.
Recovery Risk. We suppose that, at default,
any given piece of debt in the collateral pool may
be sold for a fraction of its face value whose risk-
neutral conditional expectation, given all informa-
tion available at any time t before default, is a
constant f ∈ ( 0, 1 ) that does not depend on t. The
recovery fractions of the underlying participations
are assumed to be independently distributed and
independent of default times and interest rates.
(Here again, we are referring to risk-neutral behav-
ior.) For simplicity, we assume throughout that the
tributed on (0, 1).
Collateral Credit Spreads. We suppose for
simplicity that changes in default intensities and
changes in interest rates are (risk-neutrally) inde-
pendent.9 Combined with the preceding assump-
tions, this implies that for an issuer whose default
time τ has a basic affine pre-intensity process λ, a
zero-coupon bond maturing at time t has an initial
market value of
α ( t ) + β ( t )λ ( 0 )
+ f ∫0 δ ( u )π ( u ) du ,
t
p [ t, λ ( 0 ) ] = δ ( t )e (8)
where δ(t) denotes the default-free zero-coupon
discount to time t and
d- P ( τ > u )
π ( u ) = – -----
du (9)
α ( u ) + β ( u )λ ( 0 )
= –e [ α′ ( u ) + β′ ( u )λ ( 0 ) ]
is the (risk-neutral) probability density at time u of
the default time.
The first term of Equation 8 is the market value
of a claim that pays 1 at maturity in the event of
survival. The second term is the market value of a
claim to any default recovery between times 0 and
t. The integral is computed numerically by use of
45
Financial Analysts Journal

our explicit solutions from Appendix A for α(t) and n! k n–k

q ( k, n ) = ----------------------- p ( 1 – p ) , (12)
β(t).10 ( n – k )!k!
Using this defaultable discount function, p(•),
where n! (read “n factorial”) is the product 1 × 2 ×
we can value any straight coupon bond or deter-
… × n. From this “binomial-expansion” formula, a
mine par coupon rates. For example, for quarterly
risk analysis of the CDO can be conducted by
coupon periods, the (annualized) par coupon rate,
assuming that the performance of the collateral
c(s), for maturity in s years (for an integer s > 0) is
pool is sufficiently well approximated by the per-
determined at any time t by the identity
formance of the comparison portfolio.
4s Table 1 shows the diversity score that
c(s) j
1 = p ( s, λ t ) + ----------
4 ∑ p  --4, λ t , (10) Moody’s would apply to a collateral pool of
j=1 equally sized bonds of different companies in the
same industry.11 Table 1 also shows the implied
which is easily solved for c(s). probability of default of one participation given
We develop our numerical example with con- the default of another, as well as the implied cor-
stant interest rates r, for which the risk-free dis- relations of the 0–1, survival–default, random vari-
count δ has the simple form ables associated with any two participations for
δ(t) = e –rt. (11) two levels of individual default probability,
namely, p = 0.5 and p = 0.05.
Diversity Scores. A key measure of collateral
diversity developed by Moody’s Investors Service
for CDO risk analysis is the diversity score. The Table 1. Diversity Scores, Conditional Default
diversity score of a given pool of participations is Probabilities, and Default Correlations
the number, n, of bonds in an idealized comparison
Conditional Default Default
portfolio that meets the following criteria: Number
Probability Correlation
• The total face value of the comparison portfolio of Diversity
Companies Score (p = 0.5) (p = 0.05) (p = 0.5) (p = 0.05)
is the same as the total face value of the collat-
eral pool. 1 1.00
2 1.50 0.78 0.48 0.56 0.45
• The bonds of the comparison portfolio have
3 2.00 0.71 0.37 0.42 0.34
equal face values.
4 2.33 0.70 0.36 0.40 0.32
• The comparison bonds are equally likely to
5 2.67 0.68 0.33 0.36 0.30
default, and their default is independent.
6 3.00 0.67 0.31 0.33 0.27
• The comparison bonds are, in some sense, of
7 3.25 0.66 0.30 0.32 0.26
the same average default probability as the
8 3.50 0.65 0.29 0.31 0.25
participations of the collateral pool.
9 3.75 0.65 0.27 0.29 0.24
• The comparison portfolio has the same total
10 4.00 0.64 0.26 0.28 0.23
loss risk, according to some measure of risk, as
Note: Situations in which the number of companies is greater
does the collateral pool. than 10 are evaluated on a case-by-case basis.
At least in terms of publicly available informa-
tion, it is not clear how the (equal) probability p of
default of the bonds of the comparison portfolio is
determined. A method discussed by Schorin and
Weinreich for this purpose is to assign a default Pricing Examples
probability corresponding to the weighted-average In this section, we apply a standard risk-neutral
rating score of the collateral pool by using pre- derivative valuation approach to the pricing of
determined rating scores and weights that are pro- CDO tranches. In the absence of any tractable alter-
portional to face value. Given the average rating native, we use Monte Carlo simulation of the
score, one can assign a default probability to the default times. Essentially, any intensity model
resulting “average” rating. For the choice of prob- could be substituted for the basic affine model that
ability p, Schorin and Winreich discussed the use of we have adopted here. An advantage of the affine
the historical default frequency for that rating. model is the ability one has to quickly calibrate the
A diversity score of n and a comparison-bond model to the underlying participations, in terms of
default probability of p imply, under the indepen- given correlations, default probabilities, yield
dence assumption for the comparison portfolio, spreads, and so on.
that the probability of k defaults out of n bonds of We study various alternative CDO cash flow
the comparison portfolio is structures and default risk parameters. The basic

46 ©2001, Association for Investment Management and Research®

 Risk and Valuation of Collateralized Debt Obligations

CDO structure consists of a special-purpose vehicle
that acquires a collateral portfolio of participations
(debt instruments of various obligors) and allocates
interest, principal, and default recovery cash flows
from the collateral pool to the CDO tranches—and
perhaps to a manager.
Collateral. The collateral pool has N participa-
tions. Each participation pays quarterly cash flows
to the SPV at its coupon rate until maturity or
default. At default, a participation is sold for its
recovery value and the proceeds from the sale are
also made available to the SPV.
the 10-year par-coupon spread (in basis points) and
the long-run variance of λi(t). To illustrate the qual-
itative differences between parameter sets, Figure
4 shows sample paths of new 10-year par spreads
for two issuers, one with the base-case parameters
(Set 1) and the other with pure-jump intensity (Set
2) calibrated to the same initial spread curve.
Table 2. Risk-Neutral Default Parameter Sets
Spread
Set κ θ σ l µ (bps) var∞

Let A(k) denote the subset of {1, . . ., N} contain- 1 0.6 0.0200 0.141 0.2000 0.1000 254 0.42
ing the surviving participations at the kth coupon 2 0.6 0.0156 0.000 0.2000 0.1132 254 0.43
period. The total interest income in coupon period 3 0.6 0.0373 0.141 0.0384 0.2500 253 0.49
k is then 4 0.6 0.0005 0.141 0.5280 0.0600 254 0.41

W(k) = ∑ Mi C
-----i ,
i∈A ( k ) n participation, Table 3 shows for each parameter set
where Mi is the face value of participation i and Ci
is the coupon rate on participation i.
If B(k) denotes the set of participations default-
ing between coupon periods k – 1 and k,12 the total
cash flow in period k is
Z(k) = W(k) + ∑
i∈B ( k )
( Mi – Li ) ,
where Li is the loss of face value at the default of
participation i.
For our example, the initial pool of collateral
available to the CDO structure consists of N = 100
participations that are straight quarterly coupon
10-year par bonds of equal face value. Without loss
of generality, we take the face value of each bond
to be 1.
We initiate the common and the idiosyncratic
risk factors, Xc and Xi , at their long-run means,
θc + l c µ/κ and θi + l i µ/κ, respectively. Thus, the
initial condition (and long-run mean) for each obli-
gor’s (risk-neutral) default pre-intensity is 5.33 per-
cent. Our base-case default-risk model is defined
by Parameter Set Number 1 in Table 2 and by
letting ρ = 0.5 determine the degree of diversifica-
tion. The three other parameter sets shown in Table
2 are designed to illustrate the effects of replacing
some or all of the diffusive volatility with jump
volatility or the effects of reducing the mean jump
size and increasing the mean jump arrival fre-
quency l .
All the parameter sets have the same long-run
mean θ + µl /κ. The parameters θ, σ, l , and µ were
adjusted so as to maintain essentially the same term
structure of zero-coupon yields, as illustrated in
Figure 3.13 Table 2 provides, for each parameter set,
(13) With di denoting the event of default by the ith
and each of three levels of the correlation parameter
ρ, the unconditional probability of default and the
conditional probability of default by one participa-
tion given default by another. Table 3 also shows
the diversity score of the collateral pool that is
implied by matching the (risk-neutral) variance of
the total loss of principal of the collateral portfolio
(14)
to that of a comparison portfolio of bonds of the
same individual default probabilities.14
For our basic examples, we suppose, first, that
any cash in the SPV reserve account is invested at
the default-free short-term rate. We later consider
investment of SPV free cash flows in additional
risky participations.
Sinking-Fund Tranches. We consider a CDO
structure that pays SPV cash flows to a prioritized
sequence of sinking-fund bonds and a junior sub-
ordinated residual.
In general, a sinking-fund bond with n coupon
periods per year has some remaining principal,
F(k), at coupon period k, some annualized coupon
rate c, and a scheduled interest payment at coupon
period k of F(k)c/n. In the event that the actual
interest paid, Y(k), is less than the scheduled inter-
est payment, any difference F(k)c/n – Y(k) is
accrued at the bond’s own coupon rate, c, so as to
generate an accrued unpaid interest at period k of
U(k), where U(0) = 0 and
U ( k ) =  1 + --c- U ( k – 1 ) + --nc- F ( k ) – Y ( k ) . (15)
 n
To prioritize payments in light of the default and
recovery history of the collateral pool, some pre-
payment of principal, D(k), and some contractual

January/February 2001 47
Financial Analysts Journal
Figure 3. Zero-Coupon Yield Spreads with and without Diffusion
Zero-Coupon Yield Spread
(basis points)
280
260
240
220
200
180
160
140
120
0 1 2 3
Base Case
unpaid reduction in principal, J(k), may also occur
in period k. By contract, we have D(k) + J(k) ≤ F(k –
1), so the remaining principal at quarter k is
F(k) = F(k – 1) – D(k) – J(k).
At maturity (coupon period number K), any
unpaid accrued interest and unpaid principal, U(K)
and F(K), respectively, are paid to the extent pro-
vided in the CDO contract. (A shortfall does not
constitute default so long as the contractual priori-
tization scheme is maintained.15) The total actual
payment in any coupon period k is Y(k) + D(k).
The par coupon rate on a given sinking-fund
bond is the scheduled coupon rate c with the prop-
erty that the initial market value of the bond is
equal to its initial face value, F(0). If the default-free
short rate r(k) is constant, as in our results, any
sinking-fund bond that pays all remaining princi-
pal and all accrued unpaid interest by or at its
maturity date has a par coupon rate equal to the
default-free coupon rate, no matter the timing of
the interest and principal payments.
We illustrate our initial valuation results in
terms of the par coupon spreads of the respective
tranches, which are the excess of the par coupon
48 ©2001, Association for Investment Management and Research®
4 5 6 7 8 9 10
Maturity (years)
Zero Diffusion
rates of the tranches over the default-free par cou-
pon rate.
Prioritization Schemes. We experiment with
(16)
the relative sizes and prioritization of two CDO
bond tranches, one 10-year senior sinking-fund
bond with some initial principal F1(0) = P1 and one
10-year mezzanine sinking-fund bond with initial
principal F2(0) = P2. The residual junior tranche
receives any cash flow remaining at the end of the
10-year structure. Because the base-case coupon
rates on the senior and mezzanine CDO tranches
are, by design, par rates, the base-case initial mar-
ket value of the residual tranche is P3 = 100 – P1 – P2.
At the kth coupon period, tranche j has a face
value of Fj(k) and accrued unpaid interest Uj(k)
calculated at its own coupon rate, cj. Any excess
cash flows from the collateral pool (interest income
and default recoveries) are deposited in a reserve
account. To begin, we suppose that the reserve
account earns interest at the default-free one-
period interest rate, denoted r(k) at the kth coupon
date. At maturity, coupon period K, any remaining
funds in the reserve account after payments at
quarter K to the two tranches are paid to the
 Risk and Valuation of Collateralized Debt Obligations

Figure 4. New 10-Year Par-Coupon Spreads for The reserve available before payments at
the Base-Case Parameters and for period k, R(k), is thus defined by [recall that Z(k) is
the Pure-Jump Intensity Parameters the total cash flow from the participations in
Coupon Spread period k]
(basis points)
r(k)
600 R ( k ) = 1 + ----------
4
(17)
a × [ R ( k – 1 ) – Y1 ( k – 1 ) – Y2 ( k – 1 ) ]
550
z + Z(k) .
500 Unpaid reductions in principal from default
losses occur in reverse priority order, so the junior
450 residual tranche suffers the reduction
J3(k) = min[F3(k – 1), H(k)], (18)
400
where
350
 
H ( k ) = max  ∑ L i – [ W ( k ) – Y 1 ( k ) – Y 2 ( k ) ] , 0  , (19)
300  i ∈B ( k ) 

is the total of default losses since the previous cou-

250
200
0 2 4 6
Time (years)
Base Case Pure Jumps
subordinated residual tranche. (Later, we investi-
gate the effects of investing the reserve account in
additional participations that are added to the col-
lateral pool.) We ignore management fees.
This example investigates valuation for two
prioritization schemes: Given the definition of the
sinking funds in the previous subsection, complete
specification of cash flows to all tranches requires
only that we define for the senior sinking fund and
for the mezzanine sinking fund, respectively, the
actual interest payments, Y1(k) and Y2(k); any pay-
ments of principal, D1(k) and D2(k); and any con-
tractual reductions in principal, J1(k) and J2(k).
Under our uniform prioritization scheme, inter-
est W(k) collected from the surviving participations
is allocated in priority order, with the senior
tranche getting Y1(k) = min[U1(k), W(k)] and the
mezzanine getting Y2(k) = min[U2(k), W(k) – Y1(k)].
pon date less collected and undistributed interest
income. Then, the mezzanine and senior tranches
8 10 are successively reduced in principal by, respec-
tively,
J2(k) = min[F2(k – 1), H(k) – J3(k)] (20a)
and
J1(k) = min[F1(k – 1), H(k) – J3(k) – J2(k)]. (20b)
Under uniform prioritization, no early pay-
ments of principal are made, so D1(k) = D2(k) = 0 for
k < K. At maturity, the remaining reserve is paid in
priority order, and principal and accrued interest
are treated identically, so without loss of generality
for purposes of valuation, we take
Y1(K) = Y2(K) = 0, (21a)
D1(K) = min[F1(K) + U1(K), R(K)], (21b)
and
D2(K) = min[F2(K) + U2(K), R(K) – D1(K)]. (21c)
The residual tranche finally collects
D3(K) = R(K) – Y1(K) – D1(K) – Y2(K) – D2(K). (21d)
For the alternative fast-prioritization scheme,
the senior tranche is allocated interest and principal

Table 3. Conditional Probabilities of Default and Diversity Scores

ρ = 0.1 ρ = 0.5 ρ = 0.9
Diversity Diversity Diversity
Set P(di) P(di |dj) Score P(di |dj) Score P(di |dj) Score
1 0.386 0.393 58.5 0.420 21.8 0.449 13.2
2 0.386 0.393 59.1 0.420 22.2 0.447 13.5
3 0.386 0.392 63.3 0.414 25.2 0.437 15.8
4 0.386 0.393 56.7 0.423 20.5 0.454 12.4

January/February 2001 49
Financial Analysts Journal

payments as quickly as possible until maturity or ability that more than one default will occur during
until its principal remaining is reduced to zero, one time step is very small; hence, we ignore it.
whichever is first. Until the senior tranche is paid Based on experimentation, we chose to simu-
in full, the mezzanine tranche accrues unpaid inter- late 10,000 pseudo-independent scenarios.16
est at its coupon rate. Then, the mezzanine tranche
is paid interest and principal as quickly as possible Results for Par CDO Spreads. The esti-
until maturity or until the mezzanine tranche is mated par spreads of the senior (s1) and mezzanine
retired. Finally, any remaining cash flows are allo- (s2) CDO tranches for the four-parameter sets are
cated to the residual tranche. Specifically, in cou- shown in Table 4 for various levels of overcollater-
pon period k, the senior tranche is allocated the alization and for the two prioritization schemes. To
interest payment, illustrate the accuracy of the simulation methodol-
ogy, we show in parentheses estimates of the stan-
Y1(k) = min[U1(k), Z(k)] (22a)
dard deviation of these estimated spreads resulting
and the principal payment from “Monte Carlo noise.” Table 5 and Table 6
D1(k) = min[F1(k – 1), Z(k) – Y1(k)], (22b) show estimated par spreads for the case of, respec-
tively, “low” (ρ = 0.1) and “high” (ρ = 0.9) default
where the total cash generated by the collateral correlations. In all these examples, the risk-free rate
pool, Z(k), is again defined by Equation 14. The is 0.06 and no management fees are considered.
mezzanine receives the interest payments,
Y2(k) = min[U2(k), Z(k) – Y1(k) – D1(k) – Y2(k)] (23a)
and principal payments Table 4. Par Spreads (ρ = 0.5)
D2(k) = min[F2(k – 1), Z(k) – Y1(k) – D1(k) – Y2(k)]. (23b) (estimated standard deviation in
parentheses)
Finally, any residual cash flows are paid to the
junior subordinated tranche. For this scheme, no Uniform Scheme Fast Scheme
contractual reductions in principal occur [that is, Set s1 s2 s1 s2
Ji (k) = 0]. Principal: P1 = 92.5; P2 = 5
In practice, many other types of prioritization 1 18.7 bps 636 bps 13.5 bps 292 bps
schemes are possible. For example, during the life (1) (16) (0.4) (1.6)
of a CDO, failure to meet certain contractual over- 2 17.9 589 13.5 270
collateralization ratios in many cases triggers a shift (1) (15) (0.5) (1.6)
to some version of fast prioritization. For our exam- 3 15.3 574 11.2 220
ples, the CDO yield spreads for uniform and fast (1) (14) (0.5) (1.5)
prioritization would provide upper and lower 4 19.1 681 12.7 329
bounds, respectively, on the senior spreads that (1) (17) (0.4) (1.6)
would apply if one were to add such a feature to the
uniform prioritization scheme that we illustrated. Principal: P1 = 80; P2 = 10
1 1.64 bps 67.4 bps 0.92 bps 38.9 bps
Simulation Methodology. Our computa- (0.1) (2.2) (0.1) (0.6)
tional approach consists of simulating piecewise lin- 2 1.69 66.3 0.94 39.5
ear approximations of the paths of Xc and X1, . . ., XN (0.1) (2.2) (0.01) (0.6)
for time intervals of some relatively small fixed- 3 2.08 51.6 1.70 32.4
length ∆t. (We use a ∆t interval of one week.) (0.2) (2.0) (0.2) (0.6)
Defaults during one of these intervals are simulated 4 1.15 68.1 0.37 34.6
at the corresponding discretization of the total (0.1) (2.0) (0.2) (0.6)
arrival intensity,
Figure 5 and Figure 6 illustrate the impacts on
Λ(t) = ∑ i λi ( t )1A ( i, t ) , (24)
the market values of the three tranches of a given
CDO structure of changing the correlation param-
where the variable 1A(i,t) equals 1 if issuer i has not eter ρ (with uniform prioritization). The base-case
defaulted by t and equals 0 otherwise. (That is, only CDO structures used for this illustration were
the intensities of the participations still alive are determined by uniform prioritization of senior and
summed.) When a default arrives, the identity of the mezzanine tranches whose coupon rates are at par
defaulter is drawn at random, with the probability for the base-case Parameter Set 1 and with the
that i is selected as the defaulter given by the discret- correlation parameter ρ = 0.5. For example, suppose
ization approximation of λi(t)1A(i,t)/Λ(t). The prob- this correlation parameter is moved from the base

50 ©2001, Association for Investment Management and Research®

 Risk and Valuation of Collateralized Debt Obligations

Table 5. Par Spreads (ρ = 0.1) Figure 5. Impact on Tranche Value of Correla-

Uniform Scheme Fast Scheme
tion: High Overcollateralization
(P1 = 80)
Set s1 s2 s1 s2
Principal: P1 = 92.5; P2 = 5 Premium
(percentage of face value)
1 6.7 bps 487 bps 2.7 bps 122.bps
0.5
2 6.7 492 2.9 117
3 6.3 473 2.5 102
4 7.0 507 2.7 137

Principal: P1 = 80; P2 = 10
1 0.27 bps 17.6 bps 0.13 bps 7.28 bps 0
2 0.31 17.5 0.15 7.92
3 0.45 14.9 0.40 6.89
4 0.16 19.0 0.05 6.69

–0.5
Table 6. Par Spreads (ρ = 0.9) ρ = 0.1 ρ = 0.5 ρ = 0.9
Uniform Scheme Fast Scheme
Initial Correlation
Set s1 s2 s1 s2
Senior Mezzanine Junior
Principal: P1 = 92.5; P2 = 5
1 30.7 bps 778 bps 23.9 bps 420.bps Note: Uniform prioritization. The premium is the market value
2 29.5 687 23.7 397 net of par.
3 25.3 684 20.6 325
4 32.1 896 23.1 479 Figure 6. Impact on Tranche Value of Correla-
tion: Low Overcollateralization
Principal: P1 = 80; P2 = 10 (P1 = 92.5)
1 3.17 bps 113.bps 1.87 bps 68.8 bps
Premium
2 3.28 112 1.95 70.0
(percentage of face value)
3 4.03 90 3.27 60.4
0.8
4 2.52 117 1.06 65.4
0.6
case of 0.5 to 0.9. Figure 6, which treats the case of 0.4
relatively little subordination available to the
senior tranche (P1 = 92.5), shows that the loss in 0.2
diversification reduces the market value of the 0
senior tranche from 92.5 to about 91.9. The market
value of the residual tranche, which benefits from –0.2
volatility in the manner of a call option, increases –0.4
from 2.5 to approximately 3.2, a dramatic relative
–0.6
change. Although a precise statement of convexity
is complicated by the timing of the prioritization –0.8
effects, the effect illustrated by Figures 5 and 6 is ρ = 0.1 ρ = 0.5 ρ = 0.9
along the lines of Jensen’s inequality; an increase in Initial Correlation
correlation also increases the (risk-neutral) vari-
ance of the total loss of principal. These opposing Senior Mezzanine Junior
reactions to diversification of the senior and junior Note: Uniform prioritization. The premium is the market value
tranches also show that the residual tranche may net of par.
offer some benefits to certain investors as a volatil-
ity hedge against default risk for the senior tranche.
The mezzanine tranche absorbs the net effect
of the impacts of correlation changes on the market the collateral portfolio is not affected by the corre-
values of the senior and junior residual tranches (in lation of default risk. These effects can be compared
this example, the result is a decline in market value with the impact of correlation on the par spreads of
of the mezzanine from 5.0 to approximately 4.9), the senior and mezzanine tranches that are shown
which it must do because the total market value of in Tables 4, 5, and 6. Clearly, given the relatively

January/February 2001 51
Financial Analysts Journal

small size of the mezzanine principal, the mezza- Figure 7. Risky Reinvestment: Senior Tranche
nine par spreads can be dramatically influenced by Spreads
correlation. Moreover, experimenting with various
Spread (bps)
mezzanine overcollateralization values shows that
30
the effect is ambiguous: Increasing default correla-
tion may raise or lower mezzanine spreads.
25
Prioritization Scheme. For our example,
ensuring faster payments to the senior and then to 20
the mezzanine tranches makes these tranches safer;
that is, their par coupon spreads are smaller when 15
the fast prioritization scheme is adopted. For the
senior tranche, this statement holds for two rea-
10
sons: This tranche risks no contractual loss of prin-
cipal (and hence no contractual loss of future
interest) and it loses no interest payments to the 5
mezzanine tranche. For the mezzanine tranche, the
statement holds in our example because the effect 0
of experiencing no contractual principal losses is 1 2 3 4
stronger than that of postponing the interest pay- Parameter Set
ments, which carries the risk of not receiving them
in full. Tables 4–6 provide the computed spreads. Safe Reinvestment Risky Reinvestment

Risky Reinvestment. This method can also

Figure 8. Risky Reinvestment: Mezzanine
be used to allow for collateral assets that mature
Tranche Spreads
before the termination of the CDO. The default
intensity of each new collateral asset is of the type Spread (bps)
given by Equation 5, where Xi is initialized at the 700
time of the purchase at the initial base-case level
600
(long-run mean of λi). Figure 7 and Figure 8 show
the effect of changing from safe to risky reinvest- 500
ment (with uniform prioritization). Given the
400
“short-option” aspect of the senior tranche, it
becomes less valuable when reinvestment becomes 300
risky. Note that the mezzanine tranche benefits
200
from the increased variance in this case.
100

Analytical Results 0
In this section, exploiting the symmetry assump- 1 2 3 4
tions of our special example, we provide analytical
Parameter Set
results for the probability distribution for the num-
ber of defaulting participations and the total of Safe Reinvestment Risky Reinvestment
default losses of principal, including the effects of
random recovery.
ance under permutation) in the unconditional joint
The key to calculating these probability distri-
distribution of default times,
butions exactly is the ability to explicitly compute
the probability of survival of all participations in any P(M = k) =
chosen subgroup of obligors. These explicit proba- N  P(d ∩ … ∩ d ∩ d c c (25)
bilities must be evaluated with extremely high k  1 k k + 1 ∩ … ∩ d N ),

numerical accuracy, however, because of the numer-

ous combinations of subgroups to be considered. where
For a given time horizon T, let dj denote the
 N  = -----------------------
N! -
event that obligor j defaults by T. That is, dj = k  ( N – k )!k! . (26)
{τj < T}. Also, let djc denote the event complemen-
c
tary to dj, namely, djc = {τj > T}. Let M denote the We let q(k, N) = P(d1 ∩ . . . ∩ dk ∩ d k+1 ∩ . . . ∩ dNc ).
number of defaults. Assuming symmetry (invari- The probability pj = P(d1 ∪ . . . ∪dj) that at least one

52 ©2001, Association for Investment Management and Research®

 Risk and Valuation of Collateralized Debt Obligations

of the first j names will default by T is computed Equations A2 and A3 for the case in which n = –κ,
later; for now, we take this calculation as given. p = σ2, q = –j, l = l c, and m = κθc; αi(T) and βi(T) are
Proposition 2: We have17 the explicitly given solutions of Equations A2 and
A3 for the case in which n = –κ, p = σ2, q = –1, l = l i,
N
(j + k + N + 1) k  and m = κθi.
q ( k, N ) = ∑ ( –1 ) p .
N – j  j
(27)
It is not hard to see how to generalize Proposi-
j=1
tion 2 so as to accommodate more than one type of
A proof, found in the Duffie and Gârleanu 1999 intensity—that is, how to treat a case with several
working paper, is based on a careful counting of the internally symmetric pools. Introducing each such
number of scenarios in which k participations group increases by one the dimensions of the array
default. Using the fact that the pre-intensity of the p, however, and the summation. Thus, given the
first-to-arrive τ(j) = min(τ1, . . ., τj) of the stopping relatively lengthy computation required to obtain
times τ1, . . ., τj is λ1 + . . . + λj and using the adequate accuracy for even two subgroups of issu-
independence of X1, . . ., XN and Xc, we have ers, one might prefer simulation to this analytical
approach for multiple types of issuers.
( j) Based on this analytical method, Figure 9
pj = 1 – P [ τ > T]
shows the probability q(k, 100) of k defaults within
 j
 10 years out of the original group of 100 issuers for
= 1 – E  exp – ∫0 ∑ λ i ( t ) dt 
T
(28)
 i=1  Parameter Set 1 for a correlation-determining
parameter ρ that is high (0.9) or low (0.1). Figure 10
α c ( T ) + β c ( T )X c ( 0 ) + jα i ( T ) + jβ i ( T )X i ( 0 )
= 1–e , shows the associated cumulative probability func-
tions, including the base case of ρ = 0.5. For exam-
where αc(T) and βc(T) are given explicitly in Appen- ple, from Figure 9, the likelihood of at least 60
dix A as the solutions of the ordinary differential defaults out of the original 100 participations in 10

Figure 9. Probability of k Defaults for High and Low Correlation

Probability of k Defaults
0.08

0.07

0.06

ρ = 0.1
0.05

0.04

0.03

0.02
ρ = 0.9

0.01

0
0 10 20 30 40 50 60 70 80 90 100

Number of Defaults, k

January/February 2001 53
Financial Analysts Journal
Figure 10. Cumulative Probability of Number of Defaults: High, Low, and Base-Case Correlation
Probability of k or Fewer Defaults
1.0
0.8
0.6
0.4
0.2
0
0 10 20 30 40
Number of Defaults, k
ρ = 0.9
years is on the order of 1 percent for the low-
correlation case, whereas it is roughly 12 percent
for the high-correlation case. One can use this
method to compare the probability q(k, 100) of k
defaults across all four parameter sets.18
One can also compute analytically the likeli-
hood of a total loss of principal of a given amount
x.19 The approach is to add up, over k, the proba-
bilities q(k, 100) of k defaults multiplied by the prob-
abilities that the total loss of principal from k
defaults is at least x.20 A sample of the resulting loss
distributions is illustrated in Figure 11.
One can also analytically compute the variance
of total loss of principal, from which come diversity
scores, as tabulated for our example in Table 3. A
description of the computation of diversity scores
for a general pool of collateral, not necessarily with
symmetric default risk, is in Appendix B. Given a
(risk-neutral) diversity score of n, one can estimate
CDO yield spreads by a much simpler algorithm,
which approximates by substituting the compari-
son portfolio of n independently defaulting partic-
ipations for the actual collateral portfolio.
The default times can be independently simu-
lated directly from an explicit unconditional distri-
54 ©2001, Association for Investment Management and Research®
50 60 70 80 90 100
ρ = 0.5 ρ = 0.1
bution rather than through a much more arduous
simulation of the pre-intensity processes. The algo-
rithm is roughly as follows:
• Simulate n draws from the explicit distribution
of the default time of a participation in the
comparison portfolio. Record those default
times that are before T—say, M in number—
and ignore the others.
• Simulate M fractional losses of principal.
• Allocate cash flows to the CDO tranches,
period by period, according to the desired pri-
oritization scheme.
• Discount the cash flows of each CDO tranche
to a present value at risk-free rates.
• For each tranche, average the discounted cash
flows over independently generated scenarios.
A comparison of the resulting approximation
of CDO spreads with those computed earlier is
provided for certain cases in Figures 12–14. For
well-collateralized tranches, the diversity-based
estimates of spreads are reasonably accurate (as
shown in Figures 12 and 14), at least relative to the
uncertainty that one would in any case have
regarding the actual degree of diversification in the
collateral pool. For highly subordinated tranches
and with moderate or large default correlations, the
 Risk and Valuation of Collateralized Debt Obligations

Figure 11. Probability Density of Total Losses of Principal through Default: High Correlation

Probability Density
0.07

0.06

0.05

0.04

0.03

0.02

0.01

0
0 10 20 30 40 50 60

Total Losses (percentage of face value)

Set 1 Set 3
Set 2 Set 4

Figure 12. Spread Comparisons for Senior Figure 13. Spread Comparisons for Mezzanine
Tranches: High Correlation (ρ = 0.9), Tranches: Moderate Correlation
Low Subordination (P1 = 92.5) (ρ = 0.5), Low Subordination
(P1 = 92.5, P2 = 5)
Spread (bps)
40 Spread (bps)
1,200

30 1,000

800

20
600

400
10
200

0 0
1 2 3 4 1 2 3 4

Parameter Set Parameter Set

Full-Simulation Spread Diversity-Score Spread Full-Simulation Spread Diversity-Score Spread

January/February 2001 55
Financial Analysts Journal

diversity-based spreads can be rather inaccurate, as Figure 14. Spread Comparisons for Mezzanine
can be seen in Figure 13. Tranches: Moderate Correlation
Another source of approximation error from (ρ = 0.5), High Subordination
diversity-score-based calculations is concentration (P1 = 80, P2 = 10)
risk in the original portfolio. Suppose, for example,
Spread (bps)
that the notional amount of one obligor is a large
80
fraction of the total notional amount of the collat-
eral pool. The hypothetical comparison portfolio,
with equal notional amounts to each obligor, may
60
have tail risk of default losses that is markedly
smaller than the tail risk of the actual portfolio,
despite having the same mean and variance of
40
default losses. One might allow for concentration
risk by construction of a comparison portfolio with
similar concentration but still assuming no correla-
20
tion of default losses.
Figure 15 shows the likelihood of a total loss of
principal of at least 24.3 percent of the original face
0
value as the correlation-determining parameter ρ is 1 2 3 4
varied. The figure also illustrates the calculation of
the probability of failing to meet an overcollateral- Parameter Set
ization target.
Full-Simulation Spread Diversity-Score Spread

Conclusions Figure 15. Likelihood of Total Default Losses of

Default-time correlation has a significant impact on at Least 24.3 Percent of Principal
the market values of individual tranches. The pri- within 10 Years
ority of the senior tranche, by which it is effectively
Probability
“short a call option” on the performance of the
underlying collateral pool, causes its market value 0.28
to decrease with the risk-neutral default-time cor-
relation, fixing the (risk-neutral) distribution of 0.24
individual default times. The value of the equity
piece, which resembles a call option, increases with
correlation. Intermediate tranches exhibit no clear 0.20
Jensen effect. With sufficient overcollateralization,
the option “written” (to the lower tranches) domi- 0.16
nates, but it is the other way around for sufficiently
low levels of overcollateralization.
Spreads, at least for mezzanine and senior 0.12
tranches, are not especially sensitive to the “lump-
iness” in the arrival of information about credit
0.08
quality, in that replacing the contribution of diffu- 0.1 0.3 0.5 0.7 0.9
sion with jump risks (of various types), while hold- Initial Correlation
ing constant the degree of mean reversion and the
term structure of credit spreads, plays a relatively
small role in the determination of spreads.
Regarding alternative computational meth- This work was supported in part by a grant from the
ods, if (risk-neutral) diversity scores can be evalu- Gifford Fong Associates Fund at the Graduate School of
ated accurately, which is computationally simple Business, Stanford University. We are grateful for dis-
in the framework we proposed, these scores can be cussions with Ken Singleton of Stanford University,
used to obtain good approximate market valua- Reza Bahar of Standard and Poor’s, and Sergio Kostek
tions for reasonably well-collateralized tranches. of Morgan Stanley Dean Witter. Helpful comments and
Currently, the weakest link in the chain of research assistance were provided by Jun Pan. We are
CDO analysis is the availability of empirical data also grateful for several helpful suggestions for improve-
that would bear on the correlation, actual or risk ment by Kazuhisa Uehara of the Fuji Research Institute
neutral, of default. Corporation.

56 ©2001, Association for Investment Management and Research®

 Risk and Valuation of Collateralized Debt Obligations

Appendix A. Solution for the d 1 – µa 1

d 2 = --------------------
c1
Basic Affine Model
For the basic affine model, the expectation With these explicit solutions, we can compute the
characteristic function ϕ(•) of λ(s) given λ(0),
 v + uλ ( s )  α(s) + β(s) defined by
E  exp [ ∫0 qλ ( t ) dt ]e
s
 = e (A1)
  izλ ( s )
ϕ(z) = E[e ]
is given by coefficient functions α(s) and β(s) solv- α ( s ) + β ( s )λ ( s )
(A6)
ing the following differential equations: = e ,

µβ s by taking q to equal zero and u to equal iz and

α′s = mβ s + l -----------------
- (A2) treating the coefficients α(s) and β(s) as complex.
1 – µβ s
The Laplace transform L(•) of λ(s) is computed
and analogously:
– zλ ( s )
β′s = nβ s + 1-- pβ s + q ,
2
(A3) L(z) = E[e ]
2 (A7)
α ( s ) + β ( s )λ ( s )
= e .
with the general boundary conditions α(0) = v and
β(0) = u. The survival probability (Equation 4) is In this case, we take u = –z. For details and exten-
obtained as a special case, with u = v = 0, n = –κ, sions to a general affine jump diffusion setting, see
p = σ2, q = –1, and m = κθ. Barring degenerate cases, Duffie, Pan, and Singleton (2000).
which may require separate treatment, the solutions
are given by
Appendix B. Computation of
b1 s
m ( a1 c1 – d1 ) c1 + d1 e Diversity Scores
α s = v + ------------------------------- - +  c----
- log ------------------------- m-
s
b1 c1 d1 c1 + d1  1
We define diversity score S associated with a “tar-
(A4)
b2 s get” portfolio of bonds of total principal F to be the
l ( a2 c2 – d2 ) log c-------------------------
2 + d2 e l 
+ ------------------------------ - +  ----
c - – l s number of identically and independently default-
b2 c2 d2 c2 d2  2  ing bonds, each with principal F/S, whose total
and default losses have the same variance as the target
portfolio’s default losses. The computation of S
entails computation of the variance of losses on the
b1 s
1 + a1 e target portfolio of N bonds, which we address in
β s = -------------------------
b 1 -s
, (A5) this appendix.
c1 + d1 e
For simplicity, we ignore any interest rate
where effects on losses in the calculation of diversity,
a1 = (d1 + c1)u–1 although such effects could be tractably incorpo-
rated—by the discounting of losses, for example.
d 1 ( n + 2qc 1 ) + a 1 ( nc 1 + p ) (With correlation between interest rates and
b 1 = -------------------------------------------------------------------
a1 c1 – d1 default losses, the meaningfulness of direct dis-
counting is questionable.) Also, we do not sepa-
2
– n + n – 2pq rately consider lost-coupon effects in diversity
c 1 = ---------------------------------------
2q scores. These effects, which could be particularly
2 2 important for high-premium bonds, can be cap-
n + pu + ( n + pu ) – p ( pu + 2nu + 2q )
d 1 = ( 1 – c 1 u ) ----------------------------------------------------------------------------------------------------
2 - tured along the lines of the following calculations.
2nu + pu + 2q Finally, diversity scores do not account directly for
d1 the replacement of defaulted collateral or new
a 2 = ----
c 1- investment in defaultable securities during the life
of a product, except insofar as covenants or ratings
b2 = b1 requirements stipulate a minimum diversity score
u that is to be maintained for the current collateral
c 2 = 1 – c----- portfolio for the life of the CDO structure.
1
Letting di denote the indicator of the event that
participation i defaults by a given time T and letting
Li denote the random loss of principal when this
event occurs, the variance of total default losses is

January/February 2001 57
Financial Analysts Journal

To end the computation, one uses the identities

2 2 p(1) = p1 and p(2) = 2p1 – p2, where p1 and p2 are
 N   N   N 
var  ∑ L i d i = E  ∑ L i d i – E  ∑ L i d i computed according to Equation 28 in the text, and
i = 1  i = 1  i = 1  the fact that E(Li2 ) = 1/3 and [E(Li)]2 = 1/4 if we
N assume losses are uniformly distributed on (0,1).
∑ E( Li ) E (di )
2 2
= (Other assumptions about the distribution of Li,
i=1 (B1) even allowing for correlation here, can be accom-
+ ∑ E ( Li Lj )E ( di dj ) modated.)
More generally, suppose λi(t) = bi [X(t)] and
i ≠1
N λj(t) = bj[X(t)], where X is a multivariate affine
∑ [ E ( Li ) ]
2 2
– [ E ( di ) ] . process of the general type considered in Appendix
i=1 A and bi and bj are coefficient vectors. Even in the
absence of symmetry, for any times t(i) and t(j),
Given an affine intensity model, one can com- assuming without loss of generality that t(i) ≤ t(j),
pute all terms in Equation B1. In the symmetric the probability of default by i before t(i) and of j
case, letting p(1) denote the marginal probability of before t(j) is
default of a bond and p(2) denote the joint probabil-
ity of default of any two bonds, Equation B1
∫
t(i)
– λ i ( u ) du
reduces to E ( di dj ) = 1 – E e
0

 N 
∫
t(j)
var  ∑ L i d i = Np ( 1 ) E ( L i )
2 – λ j ( u ) du
 i=1  –E e
0 (B5)
2 (B2)
+ N ( N – 1 )p ( 2 ) [ E ( L i ) ]
∫
t(j)
– b ( t )X ( t ) du
0
2 2 2 +E e ,
–N p( 1 ) [ E ( Li ) ] .

Equating the variance of the original pool to that of

the comparison pool yields where b(t) = bi + bj for t < t(i) and b(t) = bj for
t(i) ≤ t ≤ t(j). Each of the terms in Equation B5 is
analytically explicit in an affine setting, as can be
  gathered from Appendix A.
N 2  2
----  p ( 1 ) E ( L i 2 ) – p ( 1 ) [ E ( L i ) ] 2  = p ( 1 ) E ( L i ) Beginning with Equation B5, the covariance of
S  (B3)
  default losses between any pair of participations
2
+ ( N – 1 )p ( 2 ) [ E ( L i ) ] during any pair of respective time windows may
2 2 be calculated, and from that result, the total vari-
– Np ( 1 ) [ E ( L i ) ] .
ance of default losses on a portfolio and, finally,
Solving Equation B3 for the diversity score, S, one diversity score S can be calculated. With lack of
gets symmetry, however, one must take a stand on the
definition of “average” default risk to be applied to
 2 2 2
N  p( 1 ) E ( L1 ) – p( 1 ) [ E ( Li ) ]  each of the S independently defaulting issues of the
 
S = ------------------------------------------------------------------------------------------------------------------------- . (B4) comparison portfolio. We do not address that issue
2 2 2 2
p ( 1 ) E ( L 1 ) + ( N – 1 )p ( 2 ) [ E ( L i ) ] – Np ( 1 ) [ E ( L i ) ] here. A pragmatic decision could be based on fur-
ther investigation, perhaps accompanied by addi-
tional empirical work.

Notes
1. A synthetic CLO differs from a conventional CLO in that Unfortunately, regulations do not always provide the same
for a synthetic CLO, the bank originating the loans does not capital relief for a synthetic CLO as for a standard balance
actually transfer ownership of the loans to the SPV but, sheet CLO (see Punjabi and Tierney 1999).
instead, uses credit derivatives to transfer the default risk 2. This issue is related to the effects of adverse selection, but
to the SPV. A synthetic CLO may be preferred when the it also depends on the total size of the issue.
direct sale of loans to SPVs might compromise client rela- 3. Supporting technical details are provided in the Duffie and
tionships or secrecy or would be costly because of contrac- Gârleanu 1999 working paper.
tual restrictions on transferring the underlying loans.

58 ©2001, Association for Investment Management and Research®


4. An alternative would be a model in which simultaneous
defaults could be caused by certain common credit events.
An example is a multivariate exponential model (see Duffie
and Singleton 1998). Another alternative is a contagion
model, such as the static “infectious default” model of
Davis and Lo (1999).
5. An affine interest-rate process is one in which zero-coupon
yields are linear with respect to underlying state variables.
For a more precise definition, see Duffie and Kan (1996).
6. A technical condition that is sufficient for the existence of a
strictly positive solution to Equation 3 is that κθ ≥ σ2/2. We
do not require it because none of our results depends on
strict positivity.
7. A proof can be found in the Duffie and Gârleanu 1999
working paper. The method of the proof is to verify that the
Laplace transform of Xt + Yt is that of an affine process with
initial condition X0 + Y0 and parameters (κ, θ, σ, µ, l ).
8. Our model is “doubly stochastic,” in the sense that, condi-
tional on the processes λ1, . . ., λN, the default times τ1, . . .,
τn are independent and are the first jump times of counting
processes with these respective intensities. Thus, the only
source of default time correlation in our model is through
correlation in the intensity processes.
9. A modeling alternative allowing for the treatment of corre-
lated interest rate risk, and technical details, is in the 1999
Duffie and Gârleanu working paper.
10. This pricing approach was developed by Lando (1998) for
slightly different default intensity models. Lando also
allowed for correlation between interest rates and default
intensity.
11. Moody’s would not rely exclusively on the diversity score
in rating CDO tranches.
12. That is, B(k) is the subset of A(k – 1) that is not in A(k).
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January/February 2001
Risk and Valuation of Collateralized Debt Obligations
13. Because all parameter sets have the same κ parameter,
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m
17. We use the convention that   = 0 if l < 0 or m < l .
 l
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model under the objective probability is used.
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59